Schroders Quickview: What is driving current stockmarket volatility?

Equity markets are experiencing turbulence but the authorities have tools available to calm markets.

24/08/2015

Sue Noffke

Fund Manager, UK Equities

30 MinutesUnstructured Learning Time

What’s happening in financial markets?

Stockmarkets around the world have weakened sharply over the past week. This has happened together with falls in prices of several major commodities (oil, copper and iron ore), with many at 16 year lows. In addition many emerging markets currencies have fallen. This has occurred because markets are concerned about the pace of global growth.

The trigger for these global growth fears has been China, the world’s second largest economy (15% of global GDP). The Chinese stockmarket has fallen over 30% from its peak in mid June 2015 despite government efforts to contain the falls.

Chinese export data for July was very weak, down 8.3% versus the prior year. The Chinese authorities have devalued the currency over the past two weeks, leading to fears of competitive currency devaluations among emerging markets, many of which have already experienced significant currency weakness.

On Friday the independent Caixin Markit leading indicator (purchasing managers’ index) showed factory activity remained weak (at 47.1 it was the lowest reading since the depths of the Global Financial Crisis and the sixth month in a row of a below 50 reading which indicates contraction).

Other emerging markets have been weak for some time – with a heavy dependence on commodities, weaker currencies, capital flight, deterioration in fiscal positions, borrowings in US dollars where companies’ and countries’ ability to meet interest and capital payments are made more difficult by currency depreciation.

Why have markets been volatile?

The primary reason is that confidence on the sustainability of the world’s economic recovery post the Global Financial Crisis remains fragile.

Debate has intensified over future interest rate rises in the US and UK. Increased expectations of higher US interest rates this year have fuelled a rise in the US dollar and put further pressure on a range of emerging markets with capital outflows, further currency devaluations, issues over deficits and concerns over the extent of US dollar denominated borrowings.

The US Federal Reserve (Fed) had been expected to raise interest rates from their post crisis lows at the mid-September 2015 meeting, depending on data (the next major jobs data will be reported on 4 September).

The market is less confident today that the Fed will raise rates in September with probabilities falling to 37% from 50% at the start of August. As a result, the trade-weighted dollar has fallen while the yen and euro have strengthened slightly.

At the same time, markets are questioning whether the Chinese authorities can bring about a soft landing (slowing growth) without a destabilising/recessionary hard landing as the economy transitions from an export-led economy to a consumer-led one.

How long might this bout of market volatility last?

One factor to note is that we are in late August which is a time when market volumes are thin and many decision makers are away from the office. We would expect to see clearer action from the various authorities in September.

Firstly, China has scope for further stimulus – it has considerable firepower, unlike many other emerging markets. Investors are looking for cuts to the Reserve Requirement Ratio and to interest rates.

They will also be looking to see if the renminbi stabilises or if the authorities take steps to depreciate the currency further. We have seen the Chinese State Pension fund open to investments in the local stockmarket (up to 30% of US$500 billion).

In the US, the upcoming interest rate decision will dictate the future path of the US dollar. A delay could take some heat out of its strength and ease some pressure on emerging market currencies in the short term.

Regarding Europe, one consequence could be that the European Central Bank might extend its quantitative easing programme.

We would note that valuations of stockmarkets have become more attractive following the sell-offs we have seen, particularly in Europe.

We would also add that the recent corporate earnings season in Europe has been encouraging. In particular, this has been driven by domestically-focused companies rather than export-oriented firms as Europe’s economic recovery continues, and we would expect further earnings improvements in the coming quarters.

We are wary of the pitfalls of focusing too much on temporary volatility and note that such volatility can create opportunities for long-term investors.

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